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Gadziala Describes Examination Process

Mary Ann Gadziala, the associate director of the SEC's Office of Compliance Inspections and Examinations ("OCIE"), recently discussed enhancements to the examination process and current compliance challenges in remarks to the National Society of Compliance Professionals. The staff now looks to firms to take a more proactive approach, she said, both in anticipating potential problems and in implementing controls to prevent violations. Gadziala said the staff has seen significant progress and she hopes the trend toward more robust compliance programs continues.

The examination staff uses a comprehensive risk assessment process to identify and prioritize the risks to investors, registrants and the markets, according to Gadziala. The staff monitors the development of new products and market trends, she said, and identifies developing problems during examinations. The other offices and divisions at the SEC also provide compliance information to the OCIE staff which it uses to set goals and priorities, including whether to conduct a sweep of specific risk areas.

Gadziala said the staff bases its risk focused examinations on information from previous examinations, enforcement actions, customer complaints and compliance reports. It also looks at surveillance and trading information, financial reports, information from regulators and news reports. A more recent development is the reliance on high quality internal audit work conducted by each firm. If the staff determines that the firm has conducted effective and independent oversight, it may limit the areas of review to focus only on those with higher risks.

The staff strives to avoid duplicative efforts when examining firms in order to conserve resources. The examination program makes every effort to coordinate with other regulators in the areas where it has responsibilities, Gadziala said.

Gadziala described the examination process which typically begins with the procedures outlined in a brochure that is given to each firm. She added that many of the steps that are outlined in the brochure are responses to industry suggestions. The staff conducts both announced and unannounced examinations, she said. Gadziala urged firms to provide the requested documents as promptly as possible, and even piecemeal if necessary, to speed up the process.

The examiners may conduct an initial interview to learn about the firm and they may request a walk-through. The staff then proceeds to examine the books and records and to meet with firm personnel. On the last day of the examination, the staff conducts an exit interview to discuss the status of the examination, including any outstanding issues, and provides the firm with the opportunity to discuss any issues.

Once the examination is complete, Gadziala said the staff will send written notification. The notification may include areas of weakness or concern which should be addressed in writing within 30 days. A firm may request additional time, if needed, to report its corrective actions.

Current examination priorities include supervision, sales practices, risk management, financial issues and trading practices, according to Gadziala. Supervision has been a top examination priority for a long time, and she expects it to remain so, especially as the number of branch offices and remote locations grows.

Suitability and disclosure are also high priorities, Gadziala said. The staff has begun suitability examinations in six states with large retirement communities. The examinations are in the early stage, she said, but have already raised concerns with advertising and marketing materials, and with the sales of variable annuities and equity indexed annuities, she reported. New products may raise unique suitability, supervision and disclosure issues, she added, so firms should be alert to these developments.

While firms continue to make significant advances in risk management internal controls, Gadziala advised that some areas merit special attention, such as business continuity plans. Complex structured finance transactions may be subject to heightened risks, she added.

Net capital deficiencies and inaccuracies in computing net capital remain among the top findings from the staff's examinations, Gadziala reported. She also urged firms to monitor developments in portfolio managing. In the books and records area, Gadziala reminded firms about the challenge of retaining email communications, along with other correspondence and records.

Looking ahead, Gadziala predicted that future challenges will include the ever increasing number of new and complex products being developed. It is difficult to keep pace with operations, controls, compliance and training, she explained. Gadziala cited a reported 500% growth in commodities-related structured products, for example. The sales of securities products to seniors will continue to be an area of focus, she added. Technology will also pose challenges in continuing efforts to protect customer information against increasingly sophisticated hackers.

Robust and flexible controls and the continuous monitoring of risks are the best defenses against compliance problems and financial failures, she said.